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Money & Investing

For Thousands of Stocks,
Bear Market Is Here

By

Greg Ip and

Aaron LucchettiStaff Reporters of The Wall Street Journal

July 30, 1998 2:57 a.m. ET

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For thousands of stocks, the bear market has already arrived.

A week and a half of selling pressure has left the Dow Jones Industrial Average down 4.5% from its closing record set July 17. That doesn't even qualify as a correction, commonly defined as a 10% drop for an index or stock.

But behind that relatively modest blue-chip retreat is a far more dismal story for the majority of stocks.

As of Tuesday night, the average New York Stock Exchange stock was down 24.3% from its 52-week high. That's the biggest such decline since 1990, the last official bear market, according to equity strategists at
Salomon Smith Barney
. (A bear market is typically defined as a 20% or greater decline in the Dow Jones Industrials.) More stocks have been making new lows than new highs most days since late May.

On the Nasdaq Stock Market, the average stock has declined an even more dramatic 35%. Indeed, fully 30% of Big Board stocks and 51% of Nasdaq stocks are down 30% or more from their 52-week highs.

"The only thing making the market look good is the largest of the large-cap stocks," says Jeffrey Warrants, equity strategist at Salomon Smith Barney.

Scott M. Black, president of Delphi Management, adds, "We haven't seen this type of divergence since the top of the Nifty Fifty" in 1973 -- a reference to the craze for big stocks in that year. "The large-cap stocks are masking what's going on." By some measures, he says, "We've been in a bear market for a long time."

The common explanation for the divergence is that fund managers need to stay fully invested, but, wary of how earnings problems can crater a stock, are disproportionately favoring the perceived security of blue-chip growth stocks.

Stephen Dalton, senior vice president at First Capital Group, a unit of
First Union Corp.
, says every time an event upsets the market, investors dump stocks, and "if you're in one of those less-than-liquid stocks where a fundamental accident takes place, the stock goes down 50%." When confidence returns, managers quickly return to the 50 biggest, most liquid (easy to trade) stocks, but are slower to re-embrace the secondary names, he says.

The smallest stocks have been hardest hit. While Standard & Poor's 500-stock index is still up 16% so far this year, the Russell 2000 index of smaller stocks has lost 2.5% and is down 13.2% from its April high. Indeed, Salomon Smith Barney calculates that the average stock with a market value of $250 million or less is down 43% from its 52-week high, although many were in a larger-cap category at their 52-week high.

Even within the S&P 500, however, performance has gone disproportionately to the largest. Just 78 stocks provided all the year-to-date return of the S&P 500 through Tuesday, according to Salomon Smith Barney; the gainers in the remaining 420 just offset the losers. Indeed, only five stocks-
Microsoft
,
Lucent Technologies
,
General Electric
,
Wal-Mart Stores
and
Pfizer
-provided a quarter of the index's return. (The contribution of large stocks is slightly overstated because some of the stocks now defined as largest weren't among the largest at the beginning of the period.)

"The smaller the stock, the more of a bear market," that's been experienced recently, says James Melcher, president of Balestra Capital Ltd. in New York. Earlier this year, Mr. Melcher reduced the small-stock exposure in his stock portfolios to 15% from 30%. "There's just no constituency to buy these small-cap stocks," says Mr. Melcher. "Those who bought them for value have seen them go nowhere." Mr. Melcher says the proliferation of money flowing into mutual funds has helped large caps because managers need a place to put the money to work, and the stocks in the Russell index are simply too small to fit in. "The money flowing in is coming from funds, and money flowing out is from smaller stocks and individual stock holdings," he says.

Mr. Melcher isn't alone. Many fund managers appear to have increased the average size of the stocks they own this year. The median capitalization in large-stock mutual funds rose 23% to $26.2 billion between the end of last year and the end of June this year, while it rose 33% for midcap managers to $4.4 billion but a more modest 8.7% for small-cap managers, according to Morningstar Inc. Some of that increase obviously results from appreciation in the stocks themselves, but a good portion is probably also due to portfolio changes since in each case those gains are larger than the funds" average return.

Laszlo Birinyi, president of Birinyi Associates, examines how much stocks are trading on upticks, i.e., at prices above their last trade price, to determine where buying pressure is relatively more pronounced, and concludes that 25% of "net buying" on the New York Stock Exchange now is in the 30 Dow Jones industrial stocks, compared with less than 20% a year ago. Though the increase doesn't seem huge, it still represents billions of dollars going into just 30 stocks in a short period of time, says Mr. Birinyi.

Eugene Gardner, a portfolio manager for David L. Babson & Co. in Cambridge, Mass., says he has no problem finding cheap small stocks these days, mainly because so many of them have gotten beaten up recently. "It's been a pretty nasty month" for small caps, he says. And while he finds it relatively easy to buy small-cap stocks because "there are a lot of willing sellers, it gets a little more dicey" when trying to unload a stock, he says.

Balestra's Mr. Melcher says he is now unsure whether small caps can outperform unless a correction knocks all valuations down more broadly. "This is a momentum market in every sense," he says. "Investors are buying into stocks that are going up; tell me why
Gillette
is worth 50 times earnings or
Coca-Cola
is 55 with modest growth rates. There's no valuation in this market. It's lost all connection with valuation."

Some of this does appear fundamentally driven. Smaller stocks are feeling the effects of an expected slowdown in the global economy, suggests Satya Pradhuman, director of small-cap research at
Merrill Lynch
. Mr. Pradhuman reported earlier this month that earnings momentum was slowing for smaller companies for the first time since the first quarter of 1997, while large-cap earnings momentum kept growing.

"A slowing corporate profit cycle appears to be taking a toll on smaller companies," he says. "Small-cap earnings can be more volatile and the first-quarter was no exception. Larger firms typically have more room to offset adverse conditions" he says.

Whether this divergence in the market is the harbinger of a more severe correction for the major indexes is fiercely debated. The rally to July's high "was extremely narrow and accompanied by a rising complacency," says Tom McManus, an independent strategist. "That should be looked at as a danger sign. It will take more than a week to unwind the complacency that existed just a week ago."

But Neil Eigen, a value-stock manager at J&W Seligman, says a more severe correction would require a pickup in inflation. "I'd like the market to move sideways for six months" so that earnings expand to justify stock prices, he says.

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